Many people keep their distance from options trading because of the complexity associated with the investment strategy. However, you can enjoy some great advantages of options trading if you have the necessary knowledge and avoid the common mistakes other options traders make.
At times, understanding the mechanics of options trading is not enough. You need to be aware of the option trading mistakes that can jeopardize your investment strategy. Here are some major mistakes you must avoid during your options trading journey.
1. Lack of diversification
Diversification usually means buying stock in a variety of companies and industries. Options trading, however, is not as simple. There are more possibilities than purchasing promising stocks and selling ones that are not performing well.
You need to deal with both call and put strategies. Invest in tactics like married puts, covered calls, bear put spreads, and more. Incorporating multiple strategies ensures better chances of success.
2. Using margin to purchase options
You may be tempted to use a margin loan to trade options, as it often allows you to make a significant profit with a low capital investment. While you can certainly boost your profit with a margin loan, it can also amplify your losses.
The rule of thumb is only to trade money you can afford to lose. With options, your chances of losing capital also increase. Since a heavy risk is associated with purchasing on margin, you should leave it to expert traders.
3. Missing the technical indicators
As an options trader, you need to clearly understand the various dynamics of an option premium and how they work. You should know the indicators like delta, gamma, theta, and vega of a particular option before you invest in it.
For an effective options trading strategy, you need to know how to read charts and understand the different indicators displayed on them. Missing those technical indicators while making an options trading strategy may not bring positive results for you.
4. Choosing the wrong expiration date
One of the first challenges you may face while investing in options is choosing the right expiration date. The best way to deal with this is to develop an outlook on what you believe could happen using technical and fundamental analyses. It usually helps traders choose the right expiration.
You can also use a simple checklist to select the best expiration for your outlook. Ask yourself:
- How long will it take for the trade to play out, as per your estimation?
- Is holding the trade through a stock split, an earnings announcement, and other major events reasonable?
- Will there be adequate liquidity to support your trade?
Answering these questions will allow you to identify the right expiration.
5. Ignoring volatility
While trading options, you need to identify whether implied volatility is high or low. This will help you determine the price of the option premium. Furthermore, you can decide whether a contract is worth buying or not.
A clear idea of the option premium will let you decide which option strategy makes more sense for your outlook. Debit strategies will be better for relatively cheaper options, while credit strategies will be ideal for expensive ones.
6. Focusing on illiquid options
Option trades need to rely on the bid-ask spread for liquidity. This is the difference between what sellers ask for a particular asset and what buyers offer (bid). You get an illiquid option when there is a massive difference between those prices.
You will often find it difficult to find a buyer in a time of need. This can be a big challenge since the price of options swings rapidly.
Options trading can be a great way to amplify your profits. However, it can be significantly risky for those without proper knowledge. While avoiding the aforementioned mistakes can help you navigate the complexities of options trading, you must develop your understanding over time to excel in this investment strategy.